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RHT > SEC Filings for RHT > Form 10-K on 25-Apr-2013All Recent SEC Filings

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Form 10-K for RED HAT INC


25-Apr-2013

Annual Report


ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

OVERVIEW

We are a leading global provider of open source software solutions, using a community-powered approach to develop and offer reliable and high-performing operating system, middleware, virtualization, storage and cloud technologies.

Open source software is an alternative to proprietary software and represents a different model for the development and licensing of commercial software code than that typically used for proprietary software. Because open source software code is often freely shared, there are customarily no licensing fees for the use of open source software. Therefore, we do not recognize revenue from the licensing of the code itself. We provide value to our customers through the development, aggregation, integration, testing, certification, delivery, maintenance, enhancement and support of our Red Hat enterprise technologies, and by providing a level of performance, reliability, scalability, flexibility, stability and security for the enterprise technologies we package and distribute. Moreover, because communities of developers not employed by us assist with the creation of our open source offerings, opportunities for further innovation of our offerings are supplemented by these communities.

We primarily offer our enterprise technologies in the form of annual or multi-year subscriptions, and we recognize revenue over the period of the subscription agreements with our customers. We market our offerings primarily to enterprise customers.

We have focused on introducing and gaining acceptance for Red Hat enterprise technologies that comprise our open source architecture. Our operating system, Red Hat Enterprise Linux, has gained widespread ISV and IHV support. We have continued to build our open source architecture by expanding our enterprise operating system and middleware offerings and introducing virtualization, storage, cloud and other offerings.

We derive our revenue and generate cash from customers primarily from two sources: (i) subscription revenue and (ii) training and services revenue. These arrangements typically involve subscriptions to Red Hat enterprise technologies. Our revenue is affected by, among other factors, corporate, government and consumer spending levels. In evaluating the performance of our business, we consider a number of factors, including total revenue, deferred revenue, operating income, operating margin and cash flows from operations.

The arrangements with our customers that produce this revenue and cash are explained in further detail in NOTE 2-Summary of Significant Accounting Policies to our Consolidated Financial Statements.

In our fiscal year ended February 28, 2013, we focused and expect in our fiscal year ending February 28, 2014 to continue to focus on, among other things, generating (i) widespread adoption of Red Hat enterprise technologies by enterprise customers globally, (ii) increased revenue from our existing user base by renewing existing subscriptions, converting users of free versions of our enterprise technologies to paying subscribers, providing additional value to our customers and growing the number of open source enterprise technologies we offer, (iii) increased revenue by providing additional consulting and other targeted services and (iv) increased revenue from strategic acquisitions and channel partner relationships, including distributors, OEMs, IHVs, ISVs, cloud computing providers, VARs and system integrators, and from our own international expansion, among other means.

Revenue

For the year ended February 28, 2013, total revenue increased 17.3%, or $195.7 million, to $1.33 billion from $1.13 billion for the year ended February 29, 2012. Subscription revenue increased 18.9% or $182.8


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million, driven primarily by additional subscriptions related to our principal Red Hat Enterprise Linux technologies, which continue to gain broader market acceptance in mission-critical areas of computing, and our expansion of sales channels and our geographic footprint. The increase is, in part, a result of the continued migration of enterprises in industries such as financial services, government, technology and telecommunications to our open source solutions from proprietary technologies. Training and services revenue increased 7.7% or $12.9 million for the year ended February 28, 2013 as compared to the year ended February 29, 2012. The increase is driven primarily by customer interest in new products and technologies.

We believe our success is influenced by:

the extent to which we can expand the breadth and depth of our technology and service offerings;

our ability to enhance the value of subscriptions for Red Hat enterprise technologies through frequent and continuing innovations to these technologies while maintaining stable platforms over multi-year periods;

our ability to generate increasing revenue from channel partner and other strategic relationships, including distributors, OEMs, IHVs, ISVs, cloud computing providers, VARs and system integrators;

the acceptance and widespread deployment of open source technologies by enterprises and similar institutions, such as government agencies;

our ability to generate new and recurring subscription revenue for Red Hat enterprise technologies; and

our ability to provide customers with consulting and training services that generate additional revenue.

Deferred revenue, billings proxy and backlog

Deferred revenue

Our deferred revenue, current and long-term, balance at February 28, 2013 was $1.09 billion. Because of our subscription model and revenue recognition policies, deferred revenue improves predictability of future revenue. For example, current deferred revenue provides a baseline for revenue to be recognized over the next twelve months. Similarly, long-term deferred revenue provides a baseline for revenue to be recognized beyond twelve months. Total deferred revenue at February 28, 2013 increased $143.2 million or 15.1% as compared to the balance at February 29, 2012 of $946.7 million.

The change in deferred revenue reported on our Consolidated Balance Sheets of $143.2 million differs from the $162.6 million change in deferred revenue we reported on our Consolidated Statements of Cash Flows for the year ended February 28, 2013 due to changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currency into U.S. dollars.

Billings proxy

We approximate our annual billings by aggregating revenue recognized on our Consolidated Statements of Operations with the change in total deferred revenue reported on our Consolidated Statements of Cash Flows. We use the change in deferred revenue as reported on our Consolidated Statements of Cash Flows because the amount has been adjusted for the impact of changes in foreign currency exchange rates used to translate deferred revenue balances from our foreign subsidiaries' functional currencies into U.S. dollars.

Our billings proxy increased by 13.9% or $181.4 million to $1.49 billion for the year ended February 28, 2013 from $1.31 billion for the year ended February 29, 2012.

Backlog

Our backlog as of February 28, 2013 totaled approximately $1.37 billion and includes amounts billed to customers and recognized as current and long-term deferred revenue on our Consolidated Balance Sheet of


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$830.5 million and $259.5 million, respectively, plus the value of non-cancellable subscription and services agreements to be billed in the future and not reflected in our financial results ("off-balance sheet backlog") which was in excess of $280.0 million. Our off-balance sheet backlog as of February 29, 2012 was in excess of $200.0 million. The resulting increase in off-balance sheet backlog of 40.0% or $80.0 million for the year ended February 28, 2013 demonstrates increased customer commitment to our technologies.

We report our off-balance sheet backlog as a conservative approximation, often describing the amount as "in excess of", primarily because the value of underlying contracts is derived from data not yet subjected to the complete application of our revenue recognition policies. We endeavor to derive the value of our off-balance sheet backlog in a consistent manner year over year and therefore believe amounts are comparable.

Subscription revenue

Our enterprise technologies are sold under subscription agreements. These agreements typically have a one- or three-year subscription period. A subscription generally entitles a customer to, among other things, a specified level of support, as well as new versions of the software, security updates, fixes, functionality enhancements and upgrades to the technology, if and when available, and compatibility with an ecosystem of certified hardware and software applications. Our customers have the ability to purchase higher levels of subscriptions that increase the level of support the customer is entitled to receive. Subscription revenue increased sequentially for each quarter of fiscal 2013, 2012 and 2011 and is being driven primarily by the increased market acceptance and use of open source software by enterprises and our expansion of sales channels and geographic footprint during these periods.

Revenue by geography

In the year ended February 28, 2013, approximately $574.9 million or 43.3% of our revenue was generated outside the United States compared to approximately $510.5 million or 45.1% for the year ended February 29, 2012. Our international operations are expected to continue to grow as our international sales force and channels become more mature and as we enter new locations or expand our presence in existing locations. As of February 28, 2013, we had offices in more than 80 locations throughout the world.

We operate our business in three geographic regions: the Americas (U.S., Latin America and Canada); EMEA (Europe, Middle East and Africa); and Asia Pacific (principally Japan, Singapore, India, Australia, South Korea and China). Revenue generated by the Americas, EMEA and Asia Pacific for the three years ended February 28, 2013 was as follows (in thousands):

                                           Americas                  EMEA                 Asia Pacific              Total
Year ended February 28, 2013            $       855,214         $       284,922         $        188,681         $  1,328,817
Year ended February 29, 2012            $       716,033         $       257,603         $        159,467         $  1,133,103
Year ended February 28, 2011            $       583,795         $       199,646         $        125,836         $    909,277

Year-over-year revenue growth rates for our three geographical regions were as follows for the three years ended February 28, 2013:

                                           Americas                  EMEA                 Asia Pacific              Total
Year ended February 28, 2013                       19.4 %                  10.6 %                   18.3 %               17.3 %
Year ended February 29, 2012                       22.7 %                  29.0 %                   26.7 %               24.6 %
Year ended February 28, 2011                       23.0 %                  18.7 %                   19.3 %               21.5 %

Excluding the impact of changes in foreign currency exchange rates, revenue from the Americas, EMEA and Asia Pacific grew approximately 20.3%, 18.7% and 22.2%, respectively, for the year ended February 28, 2013. Excluding the impact of foreign currency exchange rates, total revenue grew 20.2% for the year ended February 28, 2013.


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As we expand further within each region, we anticipate revenue growth rates to become more similar among our geographic regions due to the similarity of products and services offered and the similarity in customer types or classes.

Gross profit margin

Gross profit margin increased to 84.9% for the year ended February 28, 2013 from 84.2% for the year ended February 29, 2012 as a result of both a product mix shift to subscriptions and a slight increase in profit margins related to training and services. Gross profit margin on training and services revenue increased to 33.4% for the year ended February 28, 2013 from 33.0% for the year ended February 29, 2012, primarily as a result of higher utilization rates for our consulting personnel and the implementation of a contractual arrangement with a global training partner that provides certain training services on our behalf and bears a portion of the fixed cost of providing such services, which makes our training expenses vary with demand.

Gross profit margin by geography

Gross profit margins generated by our geographic segments for the three years ended February 28, 2013 were as follows:

                                    Americas        EMEA        Asia Pacific       Total
    Year ended February 28, 2013         84.9 %      88.9 %              83.9 %      84.9 %
    Year ended February 29, 2012         84.4 %      87.7 %              82.7 %      84.2 %
    Year ended February 28, 2011         83.6 %      87.9 %              82.2 %      83.5 %

Regional year-over-year variations in gross profit margins are primarily due to slight product mix shifts between subscriptions and services.

As we continue to expand our sales and support services within our geographic segments, we expect gross profit margins to further converge over the long run due to the similarity of products and services offered, similarity in production and distribution methods and the similarity in customer types or classes.

Income from operations

Operating income was 15.1% and 17.6% of total revenue for the year ended February 28, 2013 and February 29, 2012, respectively. The decrease in operating income as a percentage of revenue is a result of the increase in operating expenses as a percent of revenue. Operating expenses as a percent of revenue increased to 69.8% for the year ended February 28, 2013 from 66.6% for the year ended February 29, 2012 resulting primarily from investments made in our sales and marketing and research and development functions.

Income from operations by geography

Operating income as a percentage of revenue generated by our geographic segments for the three years ended February 28, 2013 was as follows:

                                 Americas        EMEA        Asia Pacific        Total (1)
 Year ended February 28, 2013         21.2 %      25.4 %              24.5 %           15.1 %
 Year ended February 29, 2012         23.1 %      29.0 %              24.7 %           17.6 %
 Year ended February 28, 2011         19.9 %      29.6 %              24.9 %           16.0 %

(1) Total operating income as a percentage of revenue includes corporate (non-allocated) share-based compensation expense for the years ended February 28, 2013, February 29, 2012 and February 28, 2011 of $98.7 million, $79.3 million and $60.6 million, respectively. For additional information, see NOTE 20-Segment Reporting to our Consolidated Financial Statements.


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Operating margin for all of our geographic operating segments decreased for the year ended February 28, 2013 as compared to the year ended February 29, 2012 primarily as a result of the increase in operating expenses associated with increased investments in our sales and marketing and research and development functions.

Cash, cash equivalents, investments in debt and equity securities and cash flow from operations

Cash, cash equivalents and short-term and long-term available-for-sale investments in securities balances at February 28, 2013 totaled $1.32 billion. Cash generated from operating activities for the year ended February 28, 2013 totaled $465.3 million, which represents an increase of 18.7% in operating cash flow as compared to the year ended February 29, 2012. This increase is due to an increase in subscription and services revenues, billings and collections during the same period.

Our significant cash and investment balances give us a measure of flexibility to take advantage of opportunities such as acquisitions, increasing investment in international areas and repurchasing our common stock.

Foreign currency exchange rates' impact on results of operations

Approximately 43.3% of our revenue for the year ended February 28, 2013 was produced by sales outside the United States. We are exposed to significant risks of foreign currency fluctuation primarily from receivables denominated in foreign currency and are subject to transaction gains and losses, which are recorded as a component in determining net income. The statements of operations of our non-U.S. operations are translated into U.S. dollars at the average exchange rates for each applicable month in a period. To the extent the U.S. dollar weakens against foreign currencies, the translation of these foreign-currency-denominated transactions results in increased revenue and operating expenses from operations for our non-U.S. operations. Similarly, our revenue and operating expenses will decrease for our non-U.S. operations if the U.S. dollar strengthens against foreign currencies.

Using the average foreign currency exchange rates from our prior fiscal year ended February 29, 2012, our revenue and operating expenses from non-U.S. operations for the year ended February 28, 2013 would have been higher than we reported February 28, 2013 by approximately $32.9 million and $23.5 million, respectively, which would have resulted in income from operations being higher by $9.4 million.

Business combinations

On December 21, 2012, we completed the acquisition of ManageIQ, Inc. ("ManageIQ") for approximately $104.5 million in cash. ManageIQ is a provider of enterprise cloud management and automation solutions that enable organizations to deploy, manage and optimize private clouds, public clouds and virtualized infrastructures. As a result of the acquisition of ManageIQ, operating expenses increased by approximately $3.0 million for the year ended February 28, 2013.

During the year ended February 28, 2013, we acquired two businesses operating in the middleware space. These acquisitions include technologies that are complementary to our JBoss Middleware technology. One acquisition, which included certain assets and related operations acquired from Polymita Technologies S.L. ("Polymita"), closed on August 28, 2012. The second acquisition closed on September 7, 2012 and included certain assets and related operations acquired from FuseSource, a division of Progress Software Corporation ("FuseSource"). Transaction fees related to these two acquisitions totaled approximately $1.0 million for the year ended February 28, 2013 and are included in general and administrative expense on our Consolidated Statement of Operations for the year ended February 28, 2013. As a result of these two acquisitions, operating expenses increased by approximately $8.0 million for the year ended February 28, 2013.

On October 7, 2011, we acquired Gluster, Inc. ("Gluster"). Gluster develops, distributes and provides support for open-source, scale-out storage software. The acquisition expands our enterprise software offerings to


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include management of unstructured data. Total consideration transferred as part of the acquisition was $137.2 million and includes cash consideration of $135.9 million and equity consideration related to assumed, nonvested employee share-based awards of $1.2 million. The total fair value, as of October 7, 2011, of all assumed nonvested awards was $14.5 million, of which $1.2 million has been attributed to pre-acquisition employee services and accordingly has been recognized as consideration transferred. The remaining $13.3 million of fair value will be recognized as compensation expense over the remaining vesting period.

For further discussion related to our acquisitions, See NOTE 3-Business Combinations to our Consolidated Financial Statements.

Facility exit costs

In December 2011, we entered into an agreement to sublease a building in downtown Raleigh, North Carolina in which our headquarters are currently located. In connection with the transition to our new headquarters, we have endeavored to assign, sublease or otherwise dispose of our existing leases related to the two facilities that previously constituted our headquarters in Raleigh, North Carolina.

In May 2012, we entered into a sublease agreement with an unrelated third-party to lease one of the two facilities that previously constituted our headquarters. As a result, we have recognized a loss of $3.1 million for the year ended February 28, 2013 which represents the excess of our remaining obligation on the space over the agreed sublease income.

We will continue to market the remaining facility for sublease. However, to the extent we are unable to sublease or otherwise dispose of such space and recover the full amount of our remaining obligation, we will be required to recognize a loss at the date we cease using this facility, currently estimated to be May 2013. At that time, our loss, net of deferred rent credits, with respect to the remaining facility is expected to be approximately $4.8 million.

Amortization of related leasehold improvements has been accelerated to coincide with our exit from the two facilities. This change in estimated useful life resulted in incremental amortization expense of $2.9 million for the year ended February 28, 2013, and is included in general and administration expense on our Consolidated Statement of Operations.


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CRITICAL ACCOUNTING ESTIMATES

We prepare our consolidated financial statements in accordance with accounting principles generally accepted in the U.S. (U.S. GAAP). Our significant accounting policies are disclosed in NOTE 2-Summary of Significant Accounting Policies to our Consolidated Financial Statements and describe our methods for applying U.S. GAAP in areas such as revenue recognition, deferred selling costs, fair value measurements, and foreign currency translation among other areas deemed significant. In applying certain significant accounting policies, we have to make estimates and assumptions that affect our reported amounts of assets, liabilities, revenues, and expenses, as well as related disclosure of contingent assets and liabilities. In some cases, changes in the accounting estimates are reasonably likely to occur from period to period. Accordingly, actual results could differ materially from our estimates. To the extent that there are material differences between these estimates and actual results, our financial condition, results of operations or cash flows could be adversely affected. We base our estimates on past experience and other assumptions that we believe are reasonable under the circumstances, and we evaluate these estimates on an ongoing basis. We refer to accounting estimates of this type as critical accounting estimates, which we discuss further below. Critical accounting estimates are applied in the following areas:

Revenue recognition;

Goodwill and other long-lived assets;

Share-based compensation;

Income taxes; and

Loss contingencies.

Revenue recognition

Application of accounting principles related to the measurement and recognition of revenue requires judgment. For example, in transactions that include multiple elements, we must exercise judgment in determining whether adequate vendor-specific objective evidence ("VSOE") of fair value exists for each undelivered element. Changes to the elements in a transaction, the ability to identify VSOE for those elements, and changes in the fair value of the respective elements could materially impact the amount of earned and unearned revenue.

In addition, complex arrangements with nonstandard terms and conditions may require significant contract interpretation to determine appropriate accounting, including whether the deliverables specified in a multiple element transaction should be treated as separate units of accounting.

Goodwill and other long-lived assets

We make judgments about the recoverability of goodwill, identifiable intangible assets and other long-lived assets, including capitalized software purchased or developed for internal-use. The assumptions and estimates used to determine recoverability of goodwill, identifiable intangible assets and other long-lived assets are complex and subjective. They can be affected by various factors, including external factors such as industry and economic trends, and internal factors such as changes in our business strategy and our internal, multi-year forecasts for our subscription and services offerings which often include emerging technologies. Changes in any of these various factors could materially impact our financial position, results of operations and or cash flows.

Share-based compensation

We are required to make estimates and assumptions with regards to the number of share-based awards that we expect will ultimately vest and the amount of tax benefits we expect will ultimately be realized, among other things.


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Share-based awards expected to vest

We currently apply an estimated annual forfeiture rate of 10% to the service-based share awards we grant to our employees. Our estimated forfeiture rate is based on recent historical experience as well as qualitative considerations about management's expectations for attrition rates over the vesting periods. Actual attrition rates could vary significantly from our expectations resulting in material quarterly adjustments to our financial results. During the year ended February 28, 2013 we granted service-based share awards with a total fair value of $143.4 million to which we applied an estimated annual forfeiture rate of 10%.

With respect to performance-based awards that we grant to certain executive officers and senior management, we estimate the number of shares expected to vest based primarily on our most current reported financial results relative to a defined peer group's most recent reported financial results. Because past or current financial trends may not be predictive of future financial performance, our estimate of the number of shares expected to vest may differ materially from the number of shares that actually vest. The number of potential performance-based shares available to vest as of February 28, 2013 totaled 1.5 million, of which approximately 1.1 million shares are expected to vest. If all of the potential performance-based shares were to vest, we would be required to recognize additional expense of approximately $4.4 million. See NOTE 13-Share-based Awards to our Consolidated Financial Statements for further discussion related to awards outstanding and expected to vest.

Income tax benefits related to share-based awards

We recognize share-based compensation expense based on an award's grant date fair value over the requisite service period. Because we do not know the actual . . .

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